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Nor’easter

Let’s hope March of 2018 was an anomaly.  Just as signs of spring were beginning to appear, folks living in the northeast and mid-Atlantic encountered what was likely their first ever cyclone bomb.  Exhausted from shoveling snow, they were then clobbered by three more nor’easters in a three week span.  It could be we need to place more trust in Punxsutawney Phil’s early February predictions. 

The unpredictable nature of these storms reflects closely the unsettled activity in Washington, which is becoming so chaotic it looks to be finally having the effect on financial markets many had feared back in November 2016.  Stock prices, measured by the S&P 500, have begun to mimic both the unforgiving nature of recent weather – and the chaos inside the beltway.  Stocks fell in March by 2.7%.  This is on the heels of a 3.9% decline in February.  Year to date, stock prices are down 0.76%.

For some context, over the last 30 years, the S&P 500 has produced an average return of 12.2%, with an annual standard deviation of 17.3%.  There have been 5 years (17% of the time) when the return to stocks was negative, and in those years, stock prices fell on average 16.6%.  After a larger than average 21.8% return in 2017, stock prices may be reverting to the mean.

On a more granular level, the stock market looks to be attempting to assess the potential damage from a trade war.  Old school protectionism is the latest contrivance out of Washington in hopes of making America great again.   Restrictive trade, whether it leads to a trade war, will put the brakes on the positive effect foreign competition has on holding down price inflation.

The recent stock price volatility highlights the concern that fractured global supply chains may negatively impact US corporate margins.  Free trade is proven to stimulate economic growth.  Higher tariffs will eliminate the process of comparative advantage that allows all parties to benefit from globalization.  If the root of the problem is infringement of intellectual property rights, then that needs to be addressed directly, without the random and damaging effects of trade warfare.               

Recent economic data has not been compelling and the nine year expansion is long in the tooth.   Employment levels are high, so high investors have been on alert for signs of inflation.  The brutal stock sell-off in early February was ignited due to clear signs of inflation based on reports of increasing wages.  Stock investors are well aware, if a cycle of higher inflation has begun, the Fed will continue to raise interest rates.

The yield curve has shifted upward, and flattened.  This is a mixed signal.  It may well be telling us growth expectations have deteriorated.  The Federal Reserve has raised rates now for the sixth time since the first 0.25% hike in mid-2015.  Expectations are for 3 hikes this year and 3 more in 2019.  Ambitious fiscal spending, at this late point in the economic cycle, will support the Fed’s hawkish position.  The ballooning deficit, continued deficit spending and higher interest rates will raise the probability of a slowdown (recession) sometime in the near future. 

The other curiosity I’ve discussed before is the perpetual weakness in the US$.  It has been in a steady decline since the November 2016 election.  The higher interest rates available in the US would support buying dollars.  On the contrary, global investors have been selling US$s, and buying yen and euros.   It’s not clear what is causing this, though it’s likely related to increased tariffs, restrictive immigration and rising deficits.  The persistent US current account deficits are spurring talk the US$ may not be the safe-haven it once was.

The current backdrop is mixed.  Earnings estimates remain high and stocks are not excessively expensive with the forward P/E multiple in the 16x range.  Volatility has risen, making stocks harder to own.  From a contrarian perspective, this is constructive.  Yet, if the earnings forecasts falter, for whatever reason, this will spell trouble for stock prices.  With the high level of volatility, and two successive down months in stock prices, we are taking a more constructive stance, and will become more cautious if conditions persist.  Please feel free to call us if you would like to discuss further or if your investment parameters have changed since we last spoke.

Bruce Hotaling, CFA

Managing Partner

Mish Mash

Investor behavior has been by and large complacent.  The market commentary has been Pollyannaish.  The combined effect has been an extended period of positive returns and low volatility.  Stock prices, measured by the S&P 500, rose for 15 consecutive months, something they had not done in over 20 years.  Then, in February, stock prices fell by an uncomfortable 3.69%.  Sharp price drops, 4.1% on the 5th and 3.75% on the 8th, echoed swings felt prior to the onset of the financial crisis.

The market backdrop looks to have shifted.  A trend change cannot be extrapolated from one month’s returns.  Just the same, it may be that the majority of the market friendly changes (tax cuts, regulatory roll-back, loose spending) are baked in.  If this is the case, the return/risk profile stocks offer may have begun to seesaw.  Here are some observations worth your consideration.

The dominant factor influencing stock prices is earnings.  4Q 2017 was one of the strongest earnings seasons in the last 20 years, according to Bespoke Research. The “inflection” in earnings is remarkable, as they had been flat.  We tend to extrapolate data forward, and expectations going forward may be too high.

The surge in US corporate earnings has been bolstered by an up-swell in economic growth around the world.  Manufacturing PMI’s around the world are simultaneously rising, and although Europe’s emergence from the global debt crisis lagged, it’s now the catalyst for a full-fledged global economic revival.

Another boost to earnings has been a weakening US$.  This allows for a currency translation bump, when earnings from abroad are repatriated.  This tailwind has been in effect since November 2016, as the US$ has fallen roughly 15% against the Euro.

The current administration’s weak US$ policy is apparently intended to cure the trade deficit.  Curiously, the trade gap widened in January to the highest level since October 2008.  The recent imposition of tariffs on various imports may help offset the trade deficit but the true economic result will more likely be a decline in domestic growth – the opposite effect from the intended goal of making America great (protecting US industry).

The recent emphasis on fiscal policy and deficit spending is a significant concern at this point in the economic cycle.  It’s inflationary by definition, and the budget deficit may well exceed $1TN in 2018, something last accomplished in the dismal recovery from the financial crisis.  The looming cost of financing increased government debt levels is a large reason for the sharp increase in longer term interest rates.

Wages are also going up, which is good for workers earning the $7.25 federal minimum wage, but this too is a source of inflation.  Last month’s inflation data was the spark that ignited the February stock market sell-off.  The Fed has signaled it will raise rates three to four times in 2018.  Long term, there is a good likelihood the Fed (rising interest rates) will take the blame for triggering the next recession – not the ambitious policies that catalyzed the need for higher rates.

Finally, volatility is back.  This is a reflection of these disparate factors.  Stock prices move up and down and this normally tempers investor behavior.  When price volatility is low, investing in stocks becomes too easy.  The spike in volatility in February was only the second time the “fear” index hit those levels since the 2008 financial crisis.

Often times the stock market is not reacting to an event, as many TV commentators attempt to explain, rather it is signaling.  Stock prices are a leading indicator.  Along these lines, the sudden jump in price volatility (the VIX) may well be foreshadowing change.  The stock market may be telling us inflation is here and the Fed’s response will be to raise interest rates.  Four rate hikes may be the equivalent of taking away the punch bowl.  In my opinion, a raised level of caution is healthy here.  We have to be able to live with the ups and downs, and to do this may require owning less of the risky asset.  We have been repositioning portfolios to reduce oversized positions and address our view of the trend going forward.  If you would like to review this with us in more detail, please don’t hesitate to check in.

 

Bruce Hotaling, CFA

Managing Partner

Melt Up

Stock prices began 2018 right where they left off in 2017 – measured by the S&P 500, stocks recorded a total return of 5.7% in January.  The market’s buoyancy is uncharacteristic.  The last true down month in the stock market was October 2016, 15 months ago.  The steady month over month returns have in effect hypnotized investors into thinking this ongoing melt up is normal.  The monthly variability of returns to stocks in 2017 was 1.1%, the lowest measure our research produced in any year dating back to 1982 (the average monthly standard deviation was 4.2% during that time).

While I am uncomfortable with the pattern of returns, I think there is a fundamental basis for the strength in stock prices; the primary factor being earnings.  US corporations are delivering parabolic improvements in earnings, not seen in years.  According to FactSet Research, 4Q 2017 corporate earnings reports are outstanding, coming in with a blended growth rate of 13.4%.  In the last month alone, CY 2018 estimates for the S&P 500 earnings jumped 5.3% (from $147 to $155), representing the largest increase in estimates over the first month of the year since 1996.

Other factors supportive of the earnings inflection are the surprisingly weak US$ and turbo-charged global economic growth rates.  The weak US$ is difficult to understand.  Given the backdrop (Fed raising rates, wage inflation), one would expect the currency to strengthen.  Equally supportive is a healthy global economic revival boosting economic output and trade.  The IMF recently revised its global growth forecast to 3.9% – more customers buying more US made goods.

A fly in the ointment will inevitably appear, and the most likely catalyst of more normal behavior (regression to the mean) from stock prices will be higher interest rates.    When rates rise, equity risk/returns often do not look as favorable.  The yield on the US 10-year Treasury note rose to its highest level in nearly four years recently.  Inflation and unemployment data imply the Federal Reserve will remain on track to raise interest rates throughout the year.  The old adage, “don’t fight the Fed” may well lead stock investors to take pause.

The next spoiler to emerge will be skyrocketing US deficits.   Estimates are the Treasury will have to borrow up to $955 billion to make it to the September 30th fiscal year end, more than twice the year prior.  Lower tax receipts means we borrow more.  To induce lenders, interest rates will continue to rise.  Higher borrowing costs, on more debt with reduced tax receipts is a prescription for trouble.  Akin to a gambler or addict, leadership in Washington has opted for economic (and political) bliss today, at the expense of our children and grandchildren.  Eventually, someone will have to make hard choices.

Future investment returns are being pulled forward.  On the back of the one-time tax cut benefit, consumers and corporate America have their wallets out.  This will spur a flash of growth, but not long-term fundamental growth.  Further, expectations are lofty, regulations (financial and environmental) are withdrawn, and animal spirits are now alive unlike any time since the late 1920s or 1990s.  It’s no longer a fear of the stock market “crashing” or heading into a downward spiral, it’s now the fear of missing out, the age old driver of unbridled human behavior, greed.

Finally, the market place is changing in ways we cannot foresee.  For example, the emergence of ETF’s as primary investment vehicles, the emergence of crypto currencies as the next big thing, and the devolution of asset class correlations have made for a “wild west” backdrop.  A melt down, or at least some mean reversion is inevitable.  Our hope is that any downturn is measured and stair-stepped.  With this in mind, our effort is to guard against foolish impulses and focus our work on the investment policy we’ve discussed and put in place for you.  We are rebalancing over exposure to stocks and trimming specific over-weight holdings.  Changes to the tax code did not affect the favorable 15% long term capital gains rate.  Please feel free to give us a call if you would like to discuss our views in more detail or any changes to your profile.

Bruce Hotaling, CFA

Managing Partner

Animal Spirits

Happy New Year!  I wish you a peaceful and prosperous 2018.  Looking back, 2017 was prosperous for US investors, as stocks generated a total return of 21.8%, measured by the S&P 500.  It was a good year, by historical standards.  Over the last 30 years, stocks have averaged a total return of 12% with an annual standard deviation of 17%.  Other years with big returns, such as 2009, 2003 and 2013 to some degree, were classic rebound years.  Then, there was the stratospheric run in the late 1990’s when stocks averaged 28% returns for five consecutive years.

What drove stock prices in 2017?  There were several things that cumulatively led to a “perfect storm” for stocks: the US $ weakened against most major currencies, oil prices moved back into a range supportive of normal capital spending, OECD countries collectively grew, US corporations experienced double-digit earnings growth after several flat years, the prospects of corporate tax cuts stirred animal spirits, interest rates remained low and the Federal Reserve was somewhat accommodative, all with a general backdrop of full employment and improving consumer sentiment.

What should we look for in 2018?   According to FactSet Research, Wall Street analysts are forecasting S&P 500 earnings growth to continue at an 11.8% clip, with energy, materials, financials and info tech leading the way.  Stocks with higher international exposure generated superior earnings growth in ’17 and this is expected to persist in 2018.  Analysts’ estimates are for continued double-digit growth and $146.60 per share in 2018 and $161.30 in 2019.  Stock investors are thrilled to move on from the meager 3.2% pace of growth from 2012 to 2016.

The tax cuts recently passed by Congress have long been anticipated by investors.  They will fuel investor optimism for a time – until the true benefits to corporate earnings and household wallets start to pencil out.  Sadly, elected officials in Washington have given up on any sense of fiscal discipline.  The federal deficit is north of $20 trillion.  Tax cuts will unnecessarily increase the deficits (both financial and environmental), lead to higher interest rates and inflated costs (housing) and cause more sensible governments in the future to have to raise taxes to account for this generation’s need to have it all, now.

On the immediate horizon, there are flashing yellow lights – things to watch for that may stall the stock market juggernaut.  Unemployment is low, and the number of job openings is near record levels.  Labor force growth, a critical element in the economic equation, continues to decline.  With no constructive immigration policy, higher wages will ultimately spark inflation and hamper profits. In response to an uptick in inflation, the Federal Reserve will likely raise rates, making credit more expensive.

We are also faced with a chaotic backdrop that many people cannot embrace.  There is a lingering feeling of apprehension continually poked by twitter trolls and divisive memes.  The trend is troubling and mirrored to some extent in the Bitcoin bubble – an emerging tendency for people to put more faith in computer code than human institutions.  Technology is driving change that we are only beginning to understand in retrospect – there is risk these uncharted waters continue to disrupt.

My view is we have to rely on what we can measure.  The market has been trending higher, so like a good angler, the trick is to play out slack.  I think we have to defend against complacent thinking and remain disciplined.  Early this year we will be busy resetting asset allocations that have become stock heavy over the past 18 months.  This will require trimming some of our big growers, and repositioning to allow for more growth/value balance in your portfolio.  Capital gains taxes have not changed, and this works to our advantage.

There is an old stock market truism, “pigs get fat and hogs get slaughtered”.  As is the case, with heightened returns come animal spirits.  Our job, at the moment, is to defend against greed trampling common sense.  I have confidence in our process, and would be happy to review your asset allocation with you, necessary cash levels and tolerance for capital gains, as we start the New Year. 

Bruce Hotaling, CFA

Managing Partner

Taxing

It’s been a taxing year in many respects, but clearly not for investors in US stocks.    Year to date, the total return to stocks (measured by the S&P 500) is a robust 20.5%.  With the exception of a modest miss in March, returns have been positive for 13 consecutive months.  This is the longest period of consecutive returns, and with the lowest month over month standard deviation, going all the way back to 1982.

The goodness extends beyond the US.  Year to date, stock markets in most major countries around the world have produced handsome returns.  These markets include traditional economic juggernauts (Germany +27%), old line economies experiencing difficulties with their neighbors (UK +16%) and even economies no one else seems to like all that much (Russia +1%).

In spite of the soap opera in Washington, there are a number of factors propelling our stock market: earnings growth is inflecting upward, oil prices are stable, economies around the world are echoing our economic expansion, central banks around the globe are withdrawing stimulus (inflation trade) and Wall Street’s animal spirits are running wild with anticipation of the benefits from tax-cuts for corporate America.

Seasonal return patterns tell a story.  Since 1982, December is clearly the best month for stocks, with a positive return (batting average) 77% of the time and a net average return of 1.75%.  The next best month is April, with a 72% average and a net average return of 1.64%.

Stock prices have risen, and are no longer cheap.  According to FactSet Research, the trailing P/E ratio for the S&P 500 is 21.  For context, at the apex of the dot com bubble, March 2000, the market’s P/E ratio was a healthy 30.  In contrast, at the low point of the financial crisis, March 2009, the market’s P/E ratio was 10.  So, best of times, worst of times – today we are smack in the middle.

 The overarching issue on everyone’s mind is taxes.  The drama is playing out inside the Beltway, but the repercussions are being felt on Wall Street.  The effort is to spin a new tax code, lowering taxes and simultaneously spurring future growth.  Investors are licking their chops. Income taxes were briefly imposed in 1861 to help pay for the civil war.  The 3% tax was repealed in 1872.  In 1913, the 16th amendment gave Congress the authority to levy a federal tax on income.  At that time, only a small number of people actually paid. 

 Our current progressive system has taxpayers with incomes over $200,000 paying nearly 60% of all federal income taxes.   Based on early analysis of the bill, the majority of tax cuts will benefit folks in this income group, and more so for higher income groups.

 The last time a tax cut was proposed, in 2001, the Congressional Budget Office projected a $5.6 trillion surplus over 10 years.  Today, the budget office forecasts deficits will total $10.1 trillion over the next decade.  The deficit is expected to top $1 trillion a year in 2022.  Federal debt held by the public is at the highest level since shortly after World War II, at 77 percent of GDP. (NYT 9/28/17)  The political imperative to cut taxes has now superseded any view toward fiscal prudence.

 We’ve done some analysis, and a reduction in corporate taxes will boost earnings for stocks.  The puzzle is which stocks, and to what degree.  Our working assumption is that some benefit is already priced into stocks, and there is the potential for more, though this will require clear and well communicated legislation.

 At some point, I expect the market to revert to the mean.  Consumer confidence is high, as is confidence in the stock market.  These can be yellow lights.  Since Thanksgiving, the market has begun to rotate, away from the year’s big gainers, and into “safer” low growth names.  We have been anticipating this shift in leadership from growth to value.  If the rotation persists, we will look to take more profits in our highest performing stocks before the end of December.  If we wait until the new tax year to rebalance, we may be faced with a multitude of investors with the same clever thought.  My preference is to stay in front of the pack, and if we owe capital gains, to pay them from this year’s generous profits.  Please feel free to check in if you have any concerns.

Bruce Hotaling, CFA

Managing Partner

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